Federal tax changes could create misleading budget ‘bubble’ in CT

Most Americans wouldn’t feel the effects of proposed federal tax changes until the spring of 2019. But it could throw a big wrench into Connecticut’s state budget right in the coming weeks.

Taxpayers here could maximize federal tax relief down the road by stepping up state and local tax payments now.

Gov. Dannel P. Malloy’s administration fears this could mask a dangerous downward trend in state tax receipts — only for a few months — and weaken legislators’ will to close a serious state budget deficit until it is too late.

“There’s nothing about these (federal) tax changes that are going to turn things around for us in the next 18 months,” Malloy’s budget director, Office of Policy and Management Secretary Ben Barnes, told The Mirror on Friday. “I’m concerned that the short-term disruption may give the legislature the mistaken impression we don’t need to address the deteriorating revenues.”

State revenue ‘deterioration’ a growing concern

That deterioration, though significant, requires context.

The state’s largest revenue engine, its income tax, is projected to raise $9.09 billion this fiscal year. That’s still 21 percent more than it raised in 2008, before The Great Recession, and 25 percent more than it brought in during 2011 — Malloy’s first year in office.

In other words, the income tax hikes Malloy and lawmakers ordered in 2011 and 2015 — and the economic growth Connecticut experienced — did boost revenues. They just didn’t do so to the degree state officials anticipated. And they didn’t trigger any immediate drop in income tax receipts.

But income tax collections were down last fiscal year by about $193 million compared with 2016, the first year-over-year drop since the last recession.

And while they still are on pace to grow this fiscal year, there are more signs of trouble.

Income from paycheck withholding, which provides about 65 percent of all income tax receipts, only grew by 1.3 percent last fiscal year. And it’s unclear whether Connecticut will achieve the 2.1 percent growth projected for this fiscal year, Barnes said.

During much better economic times between 2004 and 2008, this portion of the income tax stream grew between 4.5 percent and 7.8 percent per year.

The other 35 percent of the state income tax stream comes from quarterly filings — the majority of which is tied to capital gains, dividends and other investment-related earnings.

About a year ago analysts were projecting this stream would grow 2.6 percent in the 2017-18 fiscal year. Now Connecticut is on pace for a 1.5 percent decline based on a report last month from executive and legislative branch analysts.

And Barnes said there were signs even that report was too optimistic.

“We could have gone down a couple hundred million dollars more,” he said, adding that all signs say Connecticut’s tax receipt slippage has not yet hit bottom. “We have to watch that very closely.”

Distorting CT tax receipts

It’s amidst this trend in Connecticut that the Republican-controlled Congress is debating federal income tax changes — that could affect things here.

Stricter limits are being considered on how much state and local tax payments can be deducted for the 2018 federal tax year — which means on income tax returns filed in the spring of 2019.

CTMIRROR.ORG file photo

State Department of Revenue Services Commissioner Kevin B. Sullivan

Connecticut residents hoping to get one more good deduction on the federal returns they file this coming April could take advantage of certain pre-payment rules now — and make larger state tax payments now.

Similarly, many businesses pay their state taxes through Connecticut income tax rather than its corporation levy. Some of those companies also are looking for ways to report earnings now — and pay more to Connecticut now — while the more favorable federal tax deductions still are available.

Revenue ‘bubble’ could mask CT budget woes

So what does that mean for Connecticut tax revenues for the rest of this fiscal year — and especially for a state budget already $208 million in deficit?

Though many uncertainties remain, both Sullivan and Barnes said whatever is brewing in response to federal changes isn’t large enough to offset the recent, downward trend in state tax receipts.

Further complicating matters is the state budget calendar.

State fiscal analysts are required by law to test revenue assumptions twice more this fiscal year, on Jan. 15 and again on April 30.

A flurry of state tax pre-payments and similar moves to take advantage — one last time — of an outgoing federal tax system, could prop up the January 15 state revenue forecast somewhat.

“But don’t assume a bubble is a trend,” Sullivan said. “No one should leap to the conclusion that the (state) budget deficit has been solved” by federal tax changes.

“There’s nothing about these (federal) tax changes that are going to turn around Connecticut’s situation” in the short term, Barnes said.

Malloy’s budget director said the calendar also is a major concern, particularly if the General Assembly allows any one-time revenue bubble to mask bigger problems with state finances.

Malloy has been pressing state legislators to begin closing the state budget deficit now, rather than wait until the regular 2018 legislative session, which starts Feb. 7 and ends May 9.

Lawmakers petitioned themselves into special session shortly after Christmas, but not to mitigate the deficit. Instead they will redirect funds from other segments of the budget to reverse an unpopular cut to a social services program which uses Medicaid funds to help the low-income elderly and the disabled pay medical expenses that Medicare doesn’t cover.

Such a move would not worsen the state budget deficit, nor would it shrink the gap.

Barnes said the administration is concerned that if January state revenue projections look promising — or even less dire than they are now — lawmakers might defer any action on the deficit until after the April 30 report, which comes out just nine days before the legislative session ends.

And while lawmakers stayed in special session for more than four months this year to resolve the budget, 2018 is a state election year. Traditionally, legislators avoid going into special session while they are campaigning for re-election because they are barred by law from raising funds during such sessions.

Filed Under:

Keith, with Jacqueline Rabe Thomas, won first prize in investigative reporting from the Education Writers Association in 2012 for a series of stories on the Board of Regents for Higher Education. The former State Capitol bureau chief for The Journal Inquirer of Manchester, Keith has spent most of 24 years as a reporter specializing in state government finances, analyzing such topics as income tax equity, waste in government and the complex funding systems behind Connecticut's transportation and social services networks. A former contributing writer to The New York Times, Keith is a graduate of and a former journalism instructor at the University of Connecticut. E-mail him at kphaneuf@ctmirror.org.

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